Bank Of America: A 20% Yield That Beats Buffett's Deal

| About: Bank of (BAC)

Will Bank Of America, (NYSE:BAC), ever work through its problems? Between the bad loans it inherited from the Countrywide and Wachovia takeovers, and the robo-foreclosure scandal, this bank has been written off by most income investors over the past few years, falling from over $53.00 in 2007, all the way down to a low of $3.14 on March 2009, at the start of the market's current 3-year rally.

Along the way, BAC had to cut its quarterly dividends from $.64 to the current $.01, as part of the bank bailout deal, and still hasn't gotten approval from the Feds to increase its dividend.

BAC's earnings, along with many other "too big to fail" banks', have been lousy, due to huge Goodwill asset write-offs of bad loans:


But it looks like an improved, smoother earnings flow may lie ahead, judging by median analysts' estimates:

BAC-QTRLY-EPSClick to enlarge

Apparently, Warren Buffett is also in the BAC optimist camp, having given BAC $5 billion in August 2011, for which he receives a 6% annual yield, plus $700 million worth of warrants at $7.00 each. The 6% yield gives him a cushion, and the $7.00 warrants offer up a potentially huge payday, if BAC bounces back.

Is BAC worth it, on any basis? Apparently, the market thinks so, having sent shares up by over 40% year-to-date.

Since BAC's reported 2011 EPS was only $.01, that gives them an exorbitant P/E of 792. Ouch! If we use BAC's adjusted 2011 EPS of $.32, we get a P/E of 24.75. Considering the forward earnings estimates, you could actually argue that BAC is very undervalued, on a P/E to Adjusted Earnings Growth basis, with a very low PEG of .32 for 2012 and 2013:

BAC-PEGClick to enlarge

Here are other valuations that support this "undervalued" theory:


Since we regular mortals can't get terms like Mr. Buffett's 6% plus warrants deal, is there a safer way to play this stock?

As it turns out, with BAC's high beta of 2.32, it has high volatility that offers very juicy put option yields.

In fact, you can earn over 21% by selling January 2014 cash secured $7.00 puts for BAC:

BAC-PUT-6-21-12Click to enlarge

Trade Advantages:

1. Time: With a January 2014 expiration, this gives BAC 18 more months to work out its earnings. It's also possible that, if BAC does improve its earnings, it will be given the go ahead to start improving its dividends once again, which should be very supportive of the stock.

2. Cash Flow/Income: In the meantime, you have the use of $150.00, for every put option contract you sell. Your cash reserve per contract sold is $700.00, a 21.43% nominal yield, or 13.79% annualized.

3. Deferred Taxes: If you hold this put option to its January 2014 expiration, you won't owe taxes on it until 2015, almost 3 years from now.

4. Low break-even price of $5.50: Considering that Mr. Buffet's warrants are at $7.00, and BAC's already low Price/Tangible Book and P/Free Cash Flow, this seems like a reasonable bet.

(You can see more info on this and over 30 other put options trades in our Cash Secured Puts Table.)

Trade Disadvantages:

1. Finite Profit Potential: Even if BAC shares go through the roof, you'll still only earn just $1.50/share, or $150.00 for every put option you sell, as opposed to sharing in a potentially larger price gain. The decision is whether to take the 21% put payment now, with its lower break-even, or to speculate on bigger potential price gain profits, by buying BAC outright, for example, at $7.92, its 6/21/12 price.

2. Long Time Horizon: A lot can happen in 18 months. However, there are many pundits who feel that having a long time horizon is one of the few advantages the average investor has.

If 18 months seems like too long of a horizon to you, consider this - in 2008, during the market meltdown, a certain well-known value investor sold over $5 billion in put premiums against the S&P 500 and 2 other indexes. His put premiums don't expire until between 2019 and 2028!

Who was this daredevil? You guessed it - Warren Buffett. And you thought he only bought stodgy value stocks. Not so - He got paid $5 billion for selling puts, money that he can use for another 7 to 16 years before he may have to pay any premiums - and this would only happen if the market crashes to below the 2008 lows.

Disclosure: Author was long BAC, and short BAC put options at the time of this writing.

Disclaimer: This article is written for informational purposes only and isn't intended as investment advice.

Disclosure: I am long BAC.

Additional disclosure: I'm also long BAC, via being short BAC put options